Monetary Policy (Instruments, Targets)

Instruments of monetary policy

Basically, the instruments of monetary policy are two types:

Quantitative Controls

Quantitative controls affect the level of aggregate demand through the supply of money, cost of money and availability of credit. They are supposed to balance the overall level of credit in economy through commercial banks. The quantitative methods include bank rate policy, open market operations and changes in reserve ratio which are discussed below:

Bank rate policy – The bank rate is the least lending rate of the central bank at which it rediscounts first class bills of exchanges and government securities held by the commercial banks. At times of inflationary pressures within the economy, central bank raises the bank rate. Borrowing from central bank becomes costly. Commercial banks borrow less from central bank. The commercial banks also raise their lending rates. So, the borrowers borrow less from commercial banks. There is contraction of credit and prices that are checked from getting lifted further. On the contrary, during depression (deflationary pressure), the central bank lowers the bank rate. So, the commercial banks will also lower their lending rates. Business men are vitalized to borrow more. Investment is also encouraged. Output, employment, income and demand start rising.

Open market operations – Open market operations refer to the sale and purchase of securities by the central bank. When prices are rising above, the central bank sells securities. The reserves of commercial banks are decreased and their lending power is contracted. Investment is discouraged and the rise in prices is examined. On the other hand, when recessionary forces start in the economy, the central bank purchases securities. The reserves of commercial banks are raised. They can lend more credit. As a result, investments, output, employment, income and aggregate demand start rising.

Changes in cash reserve ratios – Variable reserve ratio is direct and quick and effective method of controlling the power of the commercial banks to create credit. Commercial banks are required by law to keep a certain percentage of their deposits with the central bank in the form of cash reserves. This is known as the statutory minimum reserve, and the excess over this statutory minimum reserve is the excess reserve. It is on the basis of this excess reserve that commercial banks are able to create credit. The central bank has the power to vary the statutory minimum reserve ratio. As increase in the variable reserve ratio means that commercial banks are required to keep more cash with the central bank. Consequently, the size of the excess reserves with the commercial banks is reduced. Therefore, the commercial banks will be in a position to create only a smaller volume of credit. Similarly, a fall in the reserve ratio will enable the commercial banks to expand their credit.

Selective Credit Controls

Selective or qualitative methods of credit control aim at regulating and controlling the allocation of credit among various users rather than influencing the general availability of credit. We discuss below the main selective credit control instruments.

Regulation of consumer credit – It aims at regulating the consumer installment credit or hire – purchase finance. Hire – purchase finance is the method of using bank credit by the consumers to buy expensive durable consumer goods like motor cars, houses, computers, etc. A certain percentage of the price of durable goods is paid by the consumers as the down cash payment and the remaining portion of the price is financed by the bank credit. The central bank regulates the use of bank credit by consumers to buy durable consumer goods by influencing the amount of down payments and the maximum period of repayment.

Regulation of margin requirements – As we know, the commercial banks give loans to their customers against some securities. However, they do not give the full amount of value of security, but of an amount which is less than its value. The difference between the value of the security and the amount of loan granted is known as margin requirements. The banks keep the margin to protect themselves against any fall in the value of the security.

Credit Rationing – It aims at limiting the maximum or ceiling of total amount of bank loans and advances, as well, in certain cases, fixing the maximum limit of loans for specific purposes. Rationing of credit may be visible in two forms: i) the central bank may fix the maximum amount of loans and advances for every commercial bank, ii) the central bank may fix the maximum ratio of capital of a commercial bank to its total assets.

Direct action – Direct action refers to various directives issued by the central bank from time to time to the commercial banks to regulate their lending and investment activities. These direct actions may take the form of refusal of discounting facilities, refusal of loans, etc.

Moral suasion – Moral suasion is the form of persuasion, request, informal suggestion and advice to the commercial banks by the central bank.

Publicity – The central bank expresses its views about various monetary and banking policies. It may put forward its views by using facts and figures through the media of publicity. The central bank uses this method both for influencing credit policies of the commercial banks as well as to influence the public opinion in the country.

Monetary policy targets

Targets are of two types:

Operating target : Operational targets are those variables, which are closer to and influenced directly by policy instruments. The most important operating target variable is reserve money which is the monetary policy of the central bank. Reserve money is linked with intermediate target variable i.e. money supply through money multiplier. Hence, assuming preceding year’s value of money multiplier or assuming rising or declining money multiplier, projection of reserve money can be made.

Intermediate target: Intermediate targets are the missing links between the operating targets and the final goals. In other words, monetary authorities use intermediate target which lies between the policy instruments and the final goals. The main intermediate targets are money supply, bank credit and long-term interest rates.

The adoption of money as an intermediate target acts as the normal anchor, which in turn puts a constraint on the value of domestic money. A nominal anchor can help promote price stability because it helps tie down inflation expectations directly.

Reference

Bernake and Abel, Macroeconomics, Singapore, Pearson Education latest edition